Business finance
Contents: 9 sections
The five reasons a business needs finance
A business needs money before it can earn any, and again every time it grows or replaces something. 0264 names five reasons, and most questions here are built on one of them.
| Reason | What the money is for | Example |
|---|---|---|
| Start-up capital | Setting the business up before it has sold anything | Deposit on premises, the first stock, a second-hand van |
| Capital for expansion | Extra capacity, so it can sell more than it can now | A second branch, or the unit next door |
| Replacing existing non-current assets | Renewing worn-out equipment, with no gain in capacity | Replacing four delivery vans after eight years |
| Investing in new technology | Changing how it produces, not merely renewing what it has | An automated packing line, or an ecommerce site |
| Working capital | Day-to-day money, between paying out and being paid | Wages, rent and supplier bills falling due before customers pay |
Two of these blur easily. Replacing an asset keeps output where it is, while investing in new technology changes what the business can do. Start-up capital is needed once, before trading; expansion capital is wanted by a business that already trades.
Short-term and long-term needs
The length of the need decides the length of the finance, and this idea earns more marks here than any list of sources does.
| Need | How long | Suited to |
|---|---|---|
| Short-term | Weeks or a few months. A cash gap, a seasonal build-up of stock, one large supplier bill | Overdraft, trade credit |
| Long-term | Several years. A building, a machine, a fleet of vehicles, a new branch | Bank loan, share capital, venture capital, leasing, hire purchase |
Mismatching the two costs money in both directions. Borrowing over ten years to cover a gap that closes in six weeks means paying interest long after the money is needed. Funding a $200,000 machine on an overdraft is worse, because an overdraft is repayable on demand and the machine cannot be turned back into cash that fast.
Working capital
Working capital is the money a business has available to meet its day-to-day costs. Cambridge publishes this formula for 0264.
Working capital = current assets - current liabilities
Current assets are inventory, trade receivables (money owed by customers) and cash. Current liabilities are trade payables (money owed to suppliers) and any overdraft.
A shop holds inventory of $21,000, is owed $17,000 by credit customers and has $8,000 in the bank. It owes suppliers $22,000 and is $6,000 overdrawn.
Current assets = 21000 + 17000 + 8000 = $46,000
Current liabilities = 22000 + 6000 = $28,000
Working capital = 46000 - 28000 = $18,000
Working capital matters because bills arrive before the money to pay them does. A business buys materials in March, pays wages in April and is paid in June, so it must survive March to June whatever the year-end profit looks like. Too little and it cannot pay wages or suppliers, so deliveries stop and a profitable business is forced to close. Too much and it holds cash and stock that earn nothing.
Working capital is also an internal source of finance. Collecting from customers a fortnight sooner, cutting inventory that is not selling, or agreeing longer credit with a supplier all put cash back in the business without borrowing. The cost is not interest but risk: squeeze inventory too hard and you run out of stock, chase customers too hard and they buy elsewhere.
Internal sources of finance
Internal sources come from inside the business. Nothing is repaid and no outsider gains control, so they are usually considered first.
| Source | What it is | The limit on it |
|---|---|---|
| Owners' investment | The owner or partners put more of their own money in | Capped by what the owners have, and it risks their savings |
| Retained profit | Profit kept in the business instead of being taken out or paid to shareholders | Needs a profit to have been made; shareholders may object |
| Sale of unwanted assets | Selling machinery, vehicles or land the business no longer uses | Raises money once, and finding a buyer takes months |
| Working capital | Releasing cash tied up in inventory and in money owed by customers | Risks stock shortages and lost customers |
External sources of finance
External sources come from outside. They raise far more, but each has a price: interest, a share of the ownership, or conditions attached.
| Source | What it is | Watch for |
|---|---|---|
| Share capital or issuing shares | Selling new shares in a limited company. The buyer becomes part-owner and the money is never repaid | Companies only, and existing owners lose control and a share of future profit |
| Venture capital | Money put into a young, risky business with strong growth potential by a specialist firm or wealthy individual, in return for a share of the ownership and a say in how it is run | Founders give up control and a large share of future profit |
| Bank overdraft | An arrangement letting a business take more out of its current account than it holds, up to an agreed limit. Interest is charged only on the amount overdrawn | The dearest rate here, and repayable on demand |
| Leasing | Renting an asset from its owner for a regular payment rather than buying it. The business uses the asset but never owns it | Costs more over a long life, and never ends in ownership |
| Hire purchase | Buying an asset with a deposit and then fixed instalments. The business uses it from day one but owns it only after the final instalment | Repossession if instalments are missed, and a total above the cash price |
| Bank loan | A fixed sum borrowed and repaid in instalments over an agreed period, with interest | Needs security, and repayments fall due in bad months too |
| Trade credit | Taking goods from a supplier now and paying in 30, 60 or 90 days | Free while it lasts; late payment can cost the supplier |
| Government grant | A sum given by government, often not repayable, to encourage something such as locating in an area of high unemployment | Conditions attached, and slow to obtain |
| Crowdfunding | Raising small amounts from many people, usually through an online platform, in return for a reward, a product or a stake | Raises nothing if the target is missed |
An older Business Studies textbook may also cover micro-finance. The 0264 syllabus does not list it, and names crowdfunding as the alternative source to know.
What a source actually costs
Comparing sources by cost turns a knowledge answer into an analysis answer.
A business is $10,000 overdrawn for one month, and the overdraft rate is 18% a year.
Interest for a full year = 10000 x 18/100 = $1,800
Interest for one month = 1800 / 12 = $150
A machine costs $24,000 to buy outright. Leasing it costs $600 a month for five years.
Total lease payments = 600 x 60 = $36,000
Extra cost of leasing = 36000 - 24000 = $12,000
The same machine on hire purchase takes a $4,000 deposit and 24 monthly payments of $950.
Total paid = 4000 + (950 x 24) = 4000 + 22800 = $26,800
Extra cost over the cash price = 26800 - 24000 = $2,800
The overdraft looks frightening at 18% and is the cheapest thing here, because $150 buys a month. Leasing costs $12,000 more than buying and is still right for a business with no $24,000 to spare. Cost alone never settles the choice.
Choosing a source, and justifying the choice
0264 names seven factors. Each one rules something out, which is what makes them useful in an 8 or 12 mark answer.
| Factor | The question to ask | What it rules out |
|---|---|---|
| Size of business | How large and how well established? | A new firm attracts neither venture capital nor a large loan |
| Legal form of business | Sole trader, partnership, private limited or public limited? | A sole trader cannot issue shares, and a private company cannot sell them publicly |
| Amount required | A few thousand or a few hundred thousand? | Trade credit cannot fund a factory, and a share issue is not worth $5,000 |
| Length of time | Weeks, or years? | A long loan for a short gap, or an overdraft for a lasting asset |
| Existing loans | How much does it already owe? | A heavily borrowed business is refused, or charged more |
| Cost | Interest, fees, dividends, or a share of future profit | The cheapest option, if it needs cash the business has not got today |
| Purpose | What is the money actually buying? | Grants and hire purchase are tied to specific uses |
Application means using the business in front of you, not naming it. "A loan would suit this business" is knowledge. "As a sole trader, Amara cannot issue shares, so the $8,000 must come from a loan, an overdraft or her own savings" is application, because the legal form in the stem changed the answer.
Analysis is the next step in the same chain. Amara borrows $8,000 over three years, so she carries a fixed repayment every month, comfortable in her busy summer and tight in January when takings halve.
Evaluation is the decision plus what it rests on. Recommend the overdraft if the shortage is seasonal, because interest is paid only on the days she is overdrawn, and the loan if the money buys an oven lasting ten years. Then say what would change your mind: if she is already near her overdraft limit, it stops being an option whatever it costs.
Common mistakes
- Giving retained profit as a source for a brand new business. It has not traded, so there is no profit to retain.
- Suggesting share capital for a sole trader or a partnership. Only a company has shares to sell.
- Confusing leasing with hire purchase. Hire purchase ends in ownership, leasing never does.
- Saying working capital is the same as cash. Cash is one part of current assets, and working capital is what is left after current liabilities come off.
- Saying a profitable business cannot run short of working capital. It can, whenever customers pay later than suppliers must be paid.
- Answering "which source" with a list of every source and no choice. The recommendation mark needs a decision.
- Justifying a recommendation only by cost. The amount, the time period and the legal form rule options out first.
What the syllabus asks for on this topicSyllabus points
Syllabus points
- State why businesses need finance: start-up capital, capital for expansion, replacing existing non-current assets, investing in new technology, working capital.
- Distinguish short-term from long-term finance needs.
- Explain the concept and importance of working capital, and calculate it.
- Identify internal sources of finance: owners' investment, retained profit, sale of unwanted assets, working capital.
- Identify external sources: share capital or issuing shares, venture capital, bank overdrafts, leasing, hire purchase, bank loans, trade credit, government grants, crowdfunding.
- Explain the advantages and disadvantages of each.
- Apply the seven factors: size of business, legal form, amount required, length of time, existing loans, cost and purpose.
- Recommend and justify an appropriate source of finance for a given situation.
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